This gorgeous coin represents one Turkish Lira. Back in 2011, I could use this coin to buy 25 slices of bread in Türkiye. However, the same coin would only get me 6 slices of bread in 2021 (not taking into account gov support). On the other hand, here in Belgium, I needed almost 2 euros in 2011 to get these same 25 slices of bread. And, believe it or not, 10 years later, these same two euros would actually get me 27 slices of bread.
(calculations from Numbeo)
And since the market for bread is global, that’s a pretty strong indication that the problem hasn’t been the price of bread in Türkiye.
No, it’s more likely that the Lira was losing its value fast.
But okay, since this is the Money & Macro channel, we cannot just rely on bread prices to test that hypothesis.
Instead, we will use representative baskets of goods and services that reflects what people typically buy.
(1) These baskets also take into account that people in Türkiye might have slightly different needs than people in Belgium.
So, okay, very stereotypically, let’s add some extra chocolate and beer to my Belgian basket, and some more olives and white cheese to my Turkish basket.
This is what the Consumer Price Index essentially does.
If we look at the consumer price index for Belgium. 200 Euro’s would have bought me this basket in 2011. But then, today, I only get 80% of a similar basket.
So, even though I could buy more bread with a Euro after 10 years, it seems to have lost roughly 20% of its value in 10 years using the consumer price index.
And, while that sounds like a bad score,
it is actually in line with the central bank target inflation of roughly 2% inflation per year.
Next, let’s assume that this gorgeous 100 Lira note would have bought you this representative basket of goods and services in 2011.
How much do you think you could buy using that same 100 lira note, today?
Okay the answer is 20% …. just 20% of that basket….
So, in 10 years the Euro lost roughly 20% of its value while the Lira only kept 20% of its value.
On top of that, if we look at a graph of inflation in Türkiye, and compare it to inflation in Belgium, you can clearly see that, inflation in Türkiye is not only much higher … It is also much more volatile.
So, it sure sounds like the Lira is broken. But, is it really?
Well, let’s have a look at, the three classic of functions money: (1) store of value, (2) unit of account, and (3) medium of exchange.
Is the Lira a stable store of value? Clearly not.
Can you reliably use to it as a unit of account?
For example to account for what 25 slices of bread are worth?
Well, given that Turkish inflation is estimated to hit a whopping 70% this year, this is less and less the case. At that rate, we are even getting to a point where using Lira as a medium of exchange makes less sense.
But, what does make sense is that many of you, who live in Türkiye, told me that it is increasingly common for Turkish people to hold their wealth in the form of foreign currency denominated bank accounts, crypto, and gold.
Why the Lira is Broken
Luckily, understanding why the Lira is broken is rather easy.
We can simply explain it using the go-to tool of economics: supply and demand. So, if the Lira is losing purchasing power, that either means that there is too much Lira supply or not enough demand. And, if the Lira is too volatile that is obviously because supply and demand for the lira are too volatile.
But, okay, I guess this then raises a lot of new questions.
Is there too much Lira supply? Or is there just not enough demand? And why these two so volatile?
Well, to answer these questions, let’s have another look at the inflation graph we saw earlier.
As you can see, Inflation used to be fairly low in the 60s and 70s.
(2) But, at this time, Türkiye’s economy was almost completely closed of from the outside world. And it was rather small because of it. So, then in 1980, when it started opening up its economy to qualify for EU membership, expectations were high.
One of the promises of EU membership was that with this opening up to foreign money, Türkiye would be able to invest more in its economy.
This would simultaneously increase the supply of Lira’s as well as demand for Lira money by expanding the economy. Thus, it shouldn’t have increased inflation.
But, it clearly did….
What can explain this?
Well, as famous Turkish economist Dani Rodrik notes:
Instead, policy followed a mix of liberalization with patronage politics detrimental to monetary discipline. Financial liberalization reduced demand for base money at the same time that fiscal balances came under increasing strain due to the external transfer.
What he means by liberalization is opening up to international financial markets.
(3) In other words, the government now had access to the money of wealthy Western investors. And, with patronage politics Rodrik means that the government used that money to bribe voters rather to spend it productively into its economy. A less productive economy means that the government gets less tax revenues. Finally, when he talks about an increasing external transfers, he means that the government was getting more indebted to these foreign investors and therefore needed to pay them more interest payments. But remember that it’s tax base did not increase. So, The easiest way to solve this problem was then to print more Liras and convert that to foreign currency to pay off its debts.
thus leading to very high inflation and many many debt crises.
This dysfunctional dynamic between government debt and inflation became a particularly pressing political problem around 2001. This is when Türkiye got serious about joining the EU and possibly the Eurozone for which stable inflation is a stringent requirement.
And because the European dimension is so important for this story, I decided to collaborate with one of my favourite European content creators: Hugo from the channel Into Europe.
Türkiye was involved with the European Project for a long time, it signed an association agreement with the European Economic Community, the precursor to the EU in 1963, applied for the EU in 1987, and finally received candidacy status in 1999. That created momentum for reform both politically and economically.
So, it was at this point that the government brought in the IMF
Now, they gave the Turkish government some familiar advice: stop spending right now, and let efficient financial markets just do their thing.
This also meant a completely free Lira. Meaning, that its international value would now be completely determined on foreign exchange markets completely.
The result was an immediate drop in the Lira and a massive recession. But, when Erdogan got to power in 2003, Türkiye had already entered a new era of economic prosperity.
Both foreign and local finance were let loose and government spending on patronage was reigned in, the supply of Lira’s exploded…. But, as this grew the economy, so did demand for Lira. Not surprisingly, inflation was stable around 10% and Erdogan became one of Türkiye’s most popular politicians.
Yes, I know, some channels on YouTube will claim that 8.5% inflation in the U.S. is actually hyperinflation. But, for Türkiye, steady 10% inflation was like a breath of fresh air.
However, while all seemed well at the surface, the way that the country pursued its impressive growth was ultimately not sustainable for two reasons.
The first reason is that it relied too heavily on what I will call a finance-based growth model. What I mean by that is that Türkiye following China’s growth model of discouraging consumption, and encouraging exports and investment in infrastructure. Türkiye, did build some impressive export industries. But, it relied too heavily on its booming property market to bring in the foreign currency.
Foreign fuelled property booms are notorious for making people feel rich.
(4) This Temporarily pushes up the value of the currency because Lira’s are needed to invest in Turkish property.
Besides not being sustainable, this lead to two big problem.
First, by pushing the currency up, it makes Türkiye’s export industry less competitive. Second, it put a lot of purchasing power directly into the hands of Turkish citizens which was immediately spent on importing.
This then meant that whenever property markets slumped, the Lira would crash as demand for it could disappear quickly. At the same time, Turks would keep supplying Lira on the foreign exchange market because they cannot just keep importing crucial inputs such as oil, gas, and medicine. And then, every time the Lira fell, inflation would skyrocket because these imports would now get more expensive.
The second reason why Türkiye’s growth model was not sustainable is because of something that economists call dollarization.
You see, following economic orthodoxy, Türkiye actually had really high interest rates for a long time. However, one problem for economies with very high interest rates is that this incentivizes your citizens to borrow in low interest rate currencies.
Now, this is one of the classical dangers for emerging market economies. To see why, imagine that you have a 100 Lira’s worth of debt in Euro’s. But, now imagine that the Lira looses half of its value. This means that all of the sudden, you will need 200 Lira’s to pay off that debt.
This is not just a big problem for the person doing the borrowing. If all your citizens do this, it will be a big problem for your economy if your currency crashes.
Now, one clever way that countries can offset this is by is encouraging their citizens to hold foreign currency assets as well. So, Türkiye made it rather easy for citizens to do this by giving them easy access to foreign currency denominated bank accounts.
So, okay, great now sure many Turks borrowed in Dollars but many of them also held dollars.
This can actually explain why even though the Lira has been so volatile, Türkiye’s economy is still standing.
Because when it did on average country wealth remained the same.
However, what they ended up doing was completely dollarizing their economy.
(5) Imagine this. In Türkiye there were two monetary economies. A Dollar / Euro based one. And a Lira based one. The Lira based one was getting smaller every year and the Dollar /Euro based one bigger.
You can maybe already see how this combination of relying on foreign property investors, foreign imports and dollarization made the Lira more volatile over time.
Imagine the following unlikely scenario, the world is first struck by a massive pandemic. Then, after which two nearby European go to war. The global inflation that follows entices the Federal reserve to raise interest rates.
(6) In dollarized and financialized Türkiye, foreign investors start shifting money to the U.S. where they can now earn higher interest rates. This causes a drop in house prices and the Lira. Meanwhile, your citizens see the Lira plummeting and try to convert their remaining Lira deposits into Dollars. Now the sdropping even more. This now means foreign investors lose even more and so on.
As you can see, this is a doom loop.
(7) In the meantime in non-dollarized, non-financialized Türkiye .this is happening
Well, because not much has fundamentally changed about the strength of the Turkish economy. Its factories? Still there. Its tourist hotspots, still there.
You get the point.
So, why is the Lira broken? I think that its finance-based growth model and Dollarization are to blame for it becoming more fragile over time.
How to fix the Lira **
So, how can we fix the Lira?
Let’s first quickly address the standard solution that people come up with. Raise interest rates.
Can this stop the doom loop?
Yes. If you raise them high enough, you might actually be able to stop the fall of the Lira. But, it doesn’t solve the main problems of a finance-based growth model and dollarization. In fact, it could make them worse by encouraging fickle foreign investors and discouraging local Lira borrowing.
After all, Türkiye had high interest rates for years and the fundamental problems only got worse.
So, if people say, the problem with the Lira is simply Erdogan’s wacky interest rate moves, that is a very surface level analysis. Sure, it doesn’t help that he is lowering interest rates when foreign investors are already retreating and Turks are already shifting to Dollars.
No. To fix the Lira, Türkiye needs to de-financialize and de-dollarize its economy.
Sure, it will first need to stop the bleeding. Russia has shown how this can be done by jointly raising interest rates by a lot and limiting money moving out of the country. And then, once the currency has stabilized, it started lowering interest rates.
However, we must not forget that this is just a temporary solution.
After this, Türkiye should move to a more sustainable export based growth model such as those pursued by Korea and Japan.
This should actually be doable because if you look at Türkiye’s trade balance,
its industry is already in a exporting more than it imports.
What’s more, with a bit of Covid luck, tourists should soon flock back to the country and spend those lovely Euros and Dollars.
The only reason why Türkiye is still bleeding foreign exchange reserves is energy. You see, Türkiye imports almost all of its oil and gas.
But, as Hugo can tell you Türkiye’s government is already working on fixing this.
With Turkish ambitions to become a regional power-house, it’s looking to tackle the energy dependency that gives its rivals and potential rivals a strangehold over its economy. Türkiye is pursuing this policy through the construction of nuclear powerplants developing its own gas field in the black sea, connecting with the gas fields of Are, foreign Iraq, Syria and Libyia and competition of natural gas resources in the eastern Mediterranean. These efforts to shore up its currency play into Türkiye’s ambitions. With the stalled prospect of becoming an EU member and a conflicting relationship with some EU members and even the United States, which had threatened to cripple its economy under Trump, Türkiye is looking to become more self-reliant.
So, then what’s left is its dollarization problem. But, here again, the government is already working on it. Last December, it introduced a scheme that rewards savers that convert Dollars or Euros to Liras deposits. If the Lira plus 14 percent interest rate is not as profitable as the Dollar, then the government will compensate account holders of the difference. The idea here is that this stabilizes the Lira such that the government wouldn’t have to pay out anything. Pretty bold. But, so far its seems to be catching on slowly and the Lira stabilized somewhat since December.
So, the good news is that actually, the government has identified the problems and is working to fix both!
Now for the bad news….
In my opinion there three big problems.
First, the government saying one thing doesn’t mean that it will actually do it.
For example, while the government had announced that it wanted to limit foreign investment in local property, it postponed these measures when the Lira came under pressure.
Second, building a healthy economy that can support a healthy export industry is not easy.
And, given that Erdogan has a bit of a track record of appointing loyal rather than competent people in key positions, its not sure that Türkiye’s government still has the capacity to steer the economy.
Finally, it might simply be too late. The scale of Dollarization in Türkiye is insane and as we speak the Federal reserve is raising interest rates to combat inflation at home. This might put so much pressure on the Lira that its too late to really stabilize it.